Thursday, January 31, 2013

US crude oil prices have been moving up for nearly two months now. There are a number of possible explanations for this strength in crude, including ongoing Mideast unrest, expectations of higher demand from China, and of course the QE-driven "risk-on" trade.

MarketWatch: - Those include improving economic data, rising Mideast tensions, changing U.S. oil market fundamentals — with greater oil-export capacity out of Cushing, Okla., and the closure of a New Jersey refinery — and an increasing number of speculative hedge-fund net “long” market positions, or bets that oil prices will rise, he said.

March-2013 WTI contract (source: barchart)

But two recent developments make this rally particularly unusual.

1. US crude oil market is very well supplied. Inventories are materially above their the 5-year range.

Source: EIA

2. While some economists are talking about improved GDP growth in the US, the data so far is showing something quite different.

Near-term growth expectations in the US remain modest, particularly given the expiry of the payroll tax cut. Normally, slow economic growth and record supplies should limit a rally in energy prices. But these are not normal times and two other economic factors have taken center stage.

1. US monetary base hit a record last week as the Fed's asset purchase program goes into full swing. This is contributing to the "risk-on" trade.

2. And the US dollar has weakened in response, creating a positive backdrop for commodities.

US Dollar Index (DXY) (source: MarketWatch)

Yes, Mideast tensions and expectations of higher demand from Asia certainly contribute to this rise in oil prices. But absent major international supply disruptions, it will be the US monetary expansion and dollar weakness that will push crude higher - in spite of relatively weak economic fundamentals and a well supplied marketplace.

Tuesday, January 29, 2013

January US consumer confidence from the Conference Board came in materially below consensus today.

Source: Econoday

Reuters: - Consumer confidence dropped in January to its lowest level in more than a year as Americans were more pessimistic about the economic outlook and their financial prospects, according to a private sector report released on Tuesday.

The Conference Board, an industry group, said its index of consumer attitudes fell to 58.6 from an upwardly revised 66.7 in December, falling short of economists' expectations for 64. It was the lowest level since November 2011.

At the same time US equity markets continue to march higher. In fact the divergence between consumer sentiment and the stock market has become quite pronounced and is unlikely to be sustainable over the longer term. Ultimately, weak sentiment will result in lower sales.

Sunday, January 27, 2013

In another sign of increasing risk appetite, leveraged buyout (LBO) deals are completed at increasingly higher leverage (from S&P data published by Fortune). We are not at the heydays of the pre-crisis LBOs yet, but the leverage is creeping up. So far however, the amount of subordinated debt remains relatively low.

Some readers have pointed out that PitchBook data (below) seems to contradict what was compiled by S&P. The explanation is that PitchBook collects a great deal of small transaction data which includes companies too small to be tracked by S&P.

Source: PitchBook

What this is telling us is that the market has become bifurcated, with a great deal of capital chasing large transactions and larger companies. That also explains the overheated corporate bond market (see discussion), which is generally open only to larger firms. Consumer and small business credit remains relatively tight.

Last week's vote by the US House of Representatives has pushed out the budget debate into late spring, avoiding a repeat of August 2011 - for now. The Senate is likely to follow, approving the bill in its current form, with the Obama administration signing it into law.

Reuters: - Wednesday's vote by the Republican-controlled U.S. House of Representatives to extend the government's borrowing power until May 19 was no different.

It temporarily removed a hazard - a potential default within the next month - that only existed because Republicans created it. They initiated Wednesday's vote after taking a beating in public opinion polls for engaging in budget brinkmanship over the "fiscal cliff," a series of budget deadlines that came together at the end of 2012, which could have resulted in huge tax increases and spending cuts had Congress not acted to either eliminate or postpone most of them.

So how much time does the government have before the risk of "potential default" returns? After May 19th the Treasury will begin taking the so-called "Extraordinary Actions" (EA), including tapping federal pensions, and other ugly temporary measures. According to JPMorgan, "these include suspending investments of the TSP G-fund and the Exchange Stabilization
fund, suspending issuance of new securities to the CSRDF, and redemption of a limited amount of
these securities, suspending of issuance of new SLGS, and replacing Treasuries subject to the
debt limit with debt issued by the Federal Financing Bank." These are estimated to be "between $150-$200bn", providing some additional room as they did in the summer of 2011.

Based on the expected treasury issuance after May 19th (assuming we had no debt ceiling) it is possible to estimate at what point the Extraordinary Actions "juice" will run out.

Source: JPMorgan

We are looking at mid to late July before we have a potential repeat of August 2011. It's not difficult to predict what will happen in July however. The politicians will take the nation to the brink once again and at the last moment will kick the can down the road. We've seen this movie before. But for now, what Reuters calls "hazard" has been avoided.

The ECB has been receiving praise for shrinking the Eurosystem balance sheet since last summer.

MarketWatch: - The euro notched an 11-month high versus the dollar Friday, as European banks prepared to pay back a larger-than-expected chunk of cheap, three-year loans provided by the European Central Bank.

Most of the reduction is from the MRO and LTRO loan repayments by EMU periphery banks. These were funds borrowed by banks to replace lost sources of funding, including massive losses of deposits.

Source: Credit Suisse

But before congratulating Mr. Draghi on this achievement, it is important to note that the ECB has simply swapped a portion of its on-balance sheet exposure for an unlimited off-balance sheet commitment via the Outright Monetary Transactions program.

Consider Spain for example. Fundamentals of the stretched financial system, collapsing property values, and record unemployment have hardly changed. There is certainly no fundamental justification for the spectacular collapse in sovereign yields (chart below), except for the fact that the ECB is committed to buy unlimited amounts of this paper should Spain request it.

Spain: government 2-year bond yield (source: Investing.com)

Just because off-balance sheet exposure is not visible doesn't make it any less real. As a reminder of how off-balance sheet exposures can quickly appear on balance sheets, just take a look at the start of the financial crisis in 2007. Large U.S. and European financial institutions had significant off-balance sheet exposures by providing backstop guarantees to their commercial paper vehicles prior to the financial crisis. When that commercial paper could no longer be rolled, banks, particularly Citi, RBS, and Wachovia, were forced to take assets - mostly mortgage securities - onto their balance sheets. The chart below shows mortgage securities on the balance sheets of large US commercial banks. This is not a "buying spree" in late 2007 to early 2008 - it's a forced balance sheet expansion driven by commercial paper backstops.

Large US banks' holdings of mortgage securities (source: FRB)

Now the ECB has this type of unlimited backstop to periphery Eurozone governments. And the recent stabilization of the EMU sovereign paper markets is driven entirely by the off-balance sheet commitment - which could easily turn into on-balance sheet exposure. Furthermore, any attempt by the ECB to exit this commitment will result in a complete reversal of these gains - and another Eurozone crisis.

Thursday, January 24, 2013

U.S. manufacturing PMI from Markit came in stronger than expected today. The trend of manufacturing stabilization (discussed here) is intact. But the sector remains vulnerable. Each year during the post-recession period, we saw manufacturing activity pick up early in the year, just to disappoint later. It remains to be seen if this year will be any different.

As discussed earlier (see post), mortgage rates have bottomed. In spite of that, mortgage activity for home purchases (as opposed to refinancing) has risen to the highest level since 2010. The chart below shows 30y fixed mortgage rate relative to the "Purchase Index" - a measure of mortgage applications to buy a home. Mortgage rates are still near historical lows, with small increases unlikely to deter buyers.

Tuesday, January 22, 2013

US equity markets are touching multi-year highs as investors increasingly allocate to the risk-on trade. But there are a few signals that may indicate some need for caution - at least in the short-term:

What's particularly troubling about this index is that the component tracking manufacturing output prices declined while input prices rose. Not great for margins.

Richmond Fed Manufacturing Activity Index

The Philadelphia Fed Survey and The Empire State Mfg Survey also both came in materially below expectations last week.

4. At the national level, activity remains subdued. The Chicago Fed National Activity Index today came in below analysts' forecasts. U.S. economic growth is still fairly weak.

Source: Econoday

5. From a technical perspective, the world all of a sudden turned bullish. According to Merrill Lynch, investor "cash allocations fell to the lowest level since February 2011" and "allocation to bonds fell to lowest level since May 2011". We may not yet be at a level professionals would view as a contrarian signal, but this should certainly signal a need for caution.

Brazil's economy is gradually improving. DB for example is projecting a 0.8% quarter over quarter GDP growth, which looks sustainable over the longer term.

Source: DB

However, there are risks to this recovery. One of those risks has to do with Brazil's reliance on hydroelectric power - which is generally a good thing.

The Globe and Mail: - Brazil has long boasted about having one of the world’s cleanest energy grids due to its heavy use of hydro power, but a recent threat to its water supply is sending the country to the brink of energy rationing, raising concerns that Brazil will turn to more carbon-intensive energy sources to fuel its growing thirst for energy.

But it also means dependence on rainfall to fill the water reservoirs. And water levels have been significantly below normal.

The Globe and Mail: - Below-normal rains since November have depleted reservoirs at hydroelectric facilities to critical levels while consumption hits its seasonal peak.

The current situation has brought back memories of Brazil’s 2001 energy crisis, when factories and residences were forced to slash consumption amid country-wide blackouts.

Indeed, levels are below what they were during the 2001 energy crisis while power usage is 40% higher.

Source: DB

Here is a quote from the 2001 NY Times, when the power situation got ugly in Brazil:

A few months ago the Brazilian government imposed mandatory rationing of electricity. Violators, it said, would be punished. People scoffed, but more than a quarter of the country's 170 million residents are now having to adjust to a four-day work week, and they do not like it.

Much of the nation made the mandated cutback of 20 percent, or came close to it. But in nine states here in the northeast, the cutback was not even close to 20 percent, and the curtailed workweek went into effect on Oct. 22. It is expected to continue at least through November.

The region is home to 50 million people, including the largest concentrations of Brazil's poor. The cutback has forced schools and businesses to close; disrupted transportation, commerce and leisure; and intensified regional tensions.

Even though DB thinks that electricity rationing this time around is less likely, the uncertainty alone could dampen business confidence and slow economic growth. They view it as one of several structural issues (such as increased government interventions in the economy) Brazil may be facing going forward.

DB: - Even if Brazil dodges energy rationing, the uncertainty
could hurt growth by undermining business confidence in
investment. The energy crisis once again highlights
Brazil’s structural constraints on growth.

Monday, January 21, 2013

Gasoline prices could create headwinds for US economic recovery. The recent sharp rise in gasoline inventories (below) was thought to provide some relief to the consumer by bringing down fuel prices - at least in the near-term.

Source: EIA

But in spite of adequate supplies, prices remain elevated. This is driven by firm crude oil prices as well as demand for distillates from outside the US. Furthermore, the Fed's monetary policy is not helping matters.

March 2013 gasoline futures contract (source: Barchart.com)

In fact Econoday is attributing - at least in part - the unexpected weakness in Jan-2013 consumer sentiment to elevated energy prices.

Econoday: - Consumer sentiment is flat at soft levels. January's mid-month reading of 71.3 is down 1.6 points from the full month reading for December and compares with a low 70s trend during the latter part of December. Expectations continue to slip, down 1.1 points to 62.7 which is the lowest reading for this component since the aftermath of the debt-ceiling battle in 2011. Current conditions, which had been holding up better than expectations, are showing noticeable weakness, falling 3.7 points in December and another 2.2 points so far this month to 84.8. Today's decline in current conditions is not a positive signal for January's slate of economic data.

Oil prices are climbing and the consumer isn't ignoring it. One-year inflation expectations are up two tenths to 3.4 percent.

Sunday, January 20, 2013

While US retail investors are suckered into social media IPOs, a thriving market keeps many large, cash flow positive companies in institutional hands and out of public's reach. Many retail investors haven't even heard of companies such as Neodyne Industrial, Truven Health Analytics, or Suddenlink Communications. These represent some of the multi-billion dollar private transactions that took place in 2012.

Prior to the financial crisis many private companies ultimately entered the public market either via IPOs or via acquisitions by public firms. But these days the IPO market isn't exactly receptive to companies that may not have the inflated growth projections of some internet firms that we all know and love. On the other hand many larger corporations have been too gun-shy to make big strategic acquisitions and instead prefer to sit on cash. Private equity investors who in the past had a variety of exit strategies now end up holding their investments over longer periods (according to PitchBook).

That's why private companies are increasingly "traded" among private equity firms, as the secondary buyouts - purchases of companies from one set of private holders to another - rise sharply.

In fact for the first time in recent history the dollar amount of secondary transactions - trading among private equity firms - has exceeded corporate acquisitions.

Source: PitchBook

So why is it that retail investors can't participate in this market worth hundreds of billions a year? In order to participate in such transactions (usually via a private equity firm) investors need to have $5 million of liquid net worth - it's an SEC rule. And while the real money is made by institutional investors and high net worth individuals, retail investors get to own Facebook.

An number of readers responded to the post (here) on growth in US monetary base with "so what?" After all the so-called "money multiplier" has been at historical lows - meaning that the Fed's monetary expansion has not made its way into the broader economy. The argument is that all this new liquidity is "trapped" in bank reserves, as lending remains tepid.

According to this traditional school of thought, you need sharp growth in the broader money supply to generate inflation - a major threat to the economy. But there is a problem with this argument.

Greenspan's Fed also believed that as long as the money multiplier was at historical lows, loose monetary policy is justified. And in 2002-2005 the money multiplier was indeed at historical lows. This is what the trend looked like to economists before the crisis.

Inflation of course was not a major issue at the time - at least not by historical standards. And the Fed continued with loose monetary policy, as fed funds target rate hit 1% during 2003-2004. The fed began to raise rates in the second half of the decade, but by that time it was too late. Rate increases ultimately served to burst the housing bubble in 2006.

What many economists failed to realize - and many continue to do so today - was that the risk of excessive liquidity is not necessarily the overall price inflation. With US wages stagnant, those looking for a 70s-style inflation will not find it. Instead liquidity manifests itself in asset bubbles, which is exactly what was happening in the housing market at the time when the money multiplier was at the lowest levels in recent history (chart above). Plus in a global economy, inflation (including wage inflation) was simply exported to emerging markets nations.

Economists and market participants however find ways of rationalizing asset bubbles - just as they did with the housing market in the US and China's double digit growth (among other bubbles) during the first half of last decade. That's why using the traditional money multiplier as a rationale for an ultra loose monetary policy is not prudent.

As an example of where this excess liquidity may be ending up today, consider the fact that the average US corporate junk bond yield ended up at an all-time low of 5.93 last week (chart below). Of course market participants have dozens of ways of rationalizing this trend - just as they did with other markets many times before.

Therefore before dismissing the expansion in the US monetary base as inconsequential, consider the fact that in spite of low money multiplier, excess liquidity will find ways to distort markets right under our noses. And you don't need to generate headline inflation in order for these distortions to damage the economy when the correction finally takes place.

Over 60% of funds have quarterly or longer redemption frequency - which is to be expected. A large portion of the funds with longer periods between redemptions are credit funds, many of whom also restrict how much one can actually redeem per quarter (investor-level gate). This is important for these funds' survival because trigger-happy investors could quickly devastate them. Investors who "grew up" with listed equities often don't appreciate what it takes to liquidate credit assets such as bonds and CDS. And liquidity in these products is only getting worse, as the Volcker rule pushes dealers out of full market making (see discussion). This puts hedge funds at risk of having to unwind in markets where very few players stand behind their bid/ask quotes.

Hedge funds redemption frequency (source: JPMorgan PB)

Credit funds also require initial lockups (such as a year from initial investment) to make sure they build a diverse pool of investors. This way no one investor can force a devastating liquidation by pulling out. When it comes to "hard locks", lockup periods during which investors can not redeem under any circumstances, credit funds dominate.

Source: JPMorgan PB

Recently a more investor-friendly approach has been to impose the so-called "soft lockups". Investors are allowed to withdraw early, but are required to pay a penalty in these situations. Not surprisingly, credit funds have the highest penalties for early withdrawal.

Source: JPMorgan PB

As liquidity becomes more of a problem, the gap between terms for credit funds and other strategies (such as equities and futures) will only widen. Some funds will inevitably give in to investor demands for easier redemption terms (in order to raise more money). But these investors are asking for trouble. A large mismatch between the liquidity of assets (the portfolio) and of liabilities (investors' capital) will come back to haunt investors during volatile periods. That's when portfolios are dumped indiscriminately at ridiculous discounts just to meet redemptions, and investor losses are exacerbated.

Total assets of Fed's balance sheet broke through $3 trillion last week, hitting a new high, as securities purchases are stepped up (including treasuries).

Fed's balance sheet as of 1/16/13 (source: FRB)

And for the first time since this program was launched it is starting to have a material impact on bank reserves (the dynamic component of the monetary base), which spiked last week.

Reserve balances with Federal Reserve Banks (source: FRB)

As discussed earlier (see post), 2013 will look quite different from last year. The monetary base will be expanded dramatically as long as the current securities purchases program is in place. "Money printing" is in now full swing.

Thursday, January 17, 2013

As discussed earlier (see post), household formation and historically low new home inventory (see post) is stimulating construction of new homes in the US. The large shadow inventory, which many view as holding back resi construction, is simply converting some portion of homeowners into renters. But for every renter there is an owner - and there are just not enough existing homes for sale. That's why US housing starts hit a new post-recession high.

Source: Econoday

Pent-up demand for construction however is not the only market stimulated by adjustments in demographics. Demand is growing for home renovation as well. Since very few new homes have been built recently, the median age of US homes is rising, requiring additional maintenance.

Average age of home in the US (source: Merrill Lynch)

Furthermore, as homes change hands to younger owners, the need for renovation increases. That's because older homeowners spend half the national average on monthly maintenance.

Spending on monthly maintenance (source: Merrill Lynch)

ML: - Because the elderly (who own 27% of homes) have been in
their homes for much longer than the rest of the population (24 years vs < 10
years overall), they tend to own somewhat older homes. However, they spend less to
maintain them than other groups and only half the national average. Updating
and maintenance of elderly-owned homes will help drive remodeling demand for
years to come.

Other factors will also contribute to increasing demand for home renovation, such as the need to make homes more energy efficient. A number of large firms (we all know who they are) will be the direct beneficiaries of this growth market, but the trend should also benefit a variety of small businesses across the country.

Wednesday, January 16, 2013

As nations see Japan's success in weakening the yen (see discussion), some begin to take notice. Emerging markets nations often attempted to devalue their currencies in the past in order to improve competitiveness. But these days developed economies are doing it as well. This morning the Russians called these policies "currency wars", which is a good way to describe the latest developments. And such policies are not limited to Japan.

Bloomberg: - The alert from the country that chairs the Group of 20 came as Luxembourg Prime Minister Jean-Claude Juncker complained of a “dangerously high” euro and officials in Norway and Sweden expressed exchange-rate concern.

The push for weaker currencies is being driven by a need to find new sources of economic growth as monetary and fiscal policies run out of room. The risk is as each country tries to boost exports, it hurts the competitiveness of other economies and provokes retaliation.

Yesterday “will go down as the first day European policy makers fired a shot in the 2013 currency war,” said Chris Turner, head of foreign-exchange strategy at ING Groep NV in London.

In an environment such as this it is somewhat surprising to see gold treading water.

Gold (spot price, source: Barchart.com)

The key concern on the part of precious metals investors is the risk of rising US dollar - as Europe and Japan focus on pushing their currencies lower. Stronger dollar tends to put downward pressure on commodity prices.

As discussed earlier (see post), the Fed's activities in 2012 did not materially increase US bank reserves or the monetary base. 2013 however will be a different story, as the dovish Fed keeps buying assets at an accelerated pace (see discussion). That's why in spite of this latest news from Europe on "currency wars", the dollar remains subdued.

Dollar index (DXY, source: MarketWatch)

At least in the near term, precious metals and some other commodities should benefit from this global policy of "currency wars", which include a large contribution by the Fed.

Monday, January 14, 2013

Treasury yields have risen at the start of the new year but have since stalled. 1.9% yield seems to be the ceiling on the 10-year note for now.

10y treasury yield (Bloomberg)

Public sector entities continue to make it difficult for investors to short treasuries. The Fed's securities holdings hit a new record last week as the central bank began purchasing treasuries outright.

Outright securities holdings by the Fed (source: FRB)

But public sector treasury purchases are not limited to the Fed. Japan's new government wants to pull the nation out of the recession by devaluing the yen. The approach is two-fold: a massive quantitative easing program (see discussion) as well as direct market intervention. The market action by Japan's government involves selling the yen, buying dollars, and locking up the position in treasuries.

Bloomberg: - Abe’s Liberal Democratic Party pledged to consider a fund to buy foreign securities that may amount to 50 trillion yen ($558 billion) according to Nomura Securities Co. and Kazumasa Iwata, a former Bank of Japan deputy governor. JPMorgan Securities Japan Co. says the total may be double that. The purchases would further weaken a currency that has depreciated 12 percent in four months as the nation suffers through its third recession since 2008.

The risk to treasuries in the longer term is that the Fed may pull the plug on asset purchases earlier than investors anticipate (see Bloomberg story). For now however the yield increases will be limited.

Friday, January 11, 2013

With the US social safety net programs under pressure from the next round of budget negotiations, it's worth taking a look at what other nations are doing. Attached is a nice overview of the Nordic model for unemployment insurance from Jul Domingo.

VIX has been hovering near multi-year lows as investors become comfortable selling volatility. With the Fed being an implicit seller of volatility via MBS purchases (see discussion), some view it as an easy trade. In fact some traders are positioned for a "carry trade" (given how difficult it is to get carry in other markets with rates at the lows), as options decay works in the volatility sellers' favor. Market participants have discounted the impact of near-term uncertainty, particularly the impending debt ceiling negotiations. But with Washington gearing up for a fight (and Mitch McConnell actively pushing for major entitlement cuts) is this "exuberance" premature?

Market Watch: - “I would expect [the VIX] to rise over the next two months until the next deadline and resolution date” in Washington are reached, said Ron Rowland, president of Capital Cities Asset Management. “It may be just barely trending, as opposed to rallying, but I think it’s general direction will be upward.”

Frederick foresees low volatility in the VIX, within the 13 to 16 range, until late February or early March, then a pick up just ahead of the debt-ceiling deadline. “If [lawmakers] look like they are going to push it right down to the wire, and I’ll be shocked if they don’t, [the VIX] is going to run up again just like it did in the two or three days before the fiscal cliff occurred.”

At this stage it is difficult to see VIX moving materially lower and the risk seems to be to the up-side.

Thursday, January 10, 2013

An unexpected rise in China's trade surplus announced today had a material impact on global markets. The increase in trade activity shows that China's economy may be picking up steam faster than originally anticipated (see discussion).

Source: Tradingeconomics

Exports rose 14% on a YoY basis against 4.5% consensus.

Source: Econoday

Global markets responded with the "risk-on" trade. The dollar sold off while commodities rallied.

CRB Commodity Index (source: barchart.com)

One of the broader developments in recent weeks in response to the China growth story has been the rally in US transport shares. DJ Transports index has materially outperformed DJI since mid-December.

Cognito: - China is the world’s second largest and most rapidly growing major economy. It is also the world’s largest exporter. As a result, a bottom and potential turn in China’s international shipments can be reasonably viewed as a sign of a bottom and potential turn in worldwide trade. Many of the twenty companies comprising the Dow Jones Transportation Average are engaged in the international shipment of goods. Hence their sales and earnings would benefit from an increase in global trade. Global transportation bellwether Federal Express/FDX is a prime example. Perhaps not coincidentally, FDX is attempting to emerge from a substantial reverse head-and-shoulders consolidation spanning more than two years!

This is not unique to the US, with Australian transport shares rallying as well. An improvement in the transport sector is good news for global growth because it tends to lead economic expansion.